THE J.P. MORGAN GUIDE TO CREDIT DERIVATIVES ppt

THE J.P. MORGAN GUIDE

TO CREDIT DERIVATIVES

With Contributions from the RiskMetrics Group

Published by

Contacts

NEW YORK

Blythe Masters

Tel: +1 (212) 648 1432

E-mail: masters_ blythe@jpmorgan .com

LONDON

Jane Herring

Tel: +44 (0) 171 2070

E-mail: herring_ jane@jpmorgan .com

Oldrich Masek

Tel: +44 (0) 171 325 9758

E-mail: masek_oldrich@jpmorgan .com

TOKYO

Muneto Ikeda

Tel: +8 (3) 5573 1736

E-mail: ikeda_muneto@jpmorgan .com

NEW YORK

Sarah Xie

Tel: +1 (212) 981 7475

E-mail: sarah.xie@riskmetrics .com

LONDON

Rob Fraser

Tel: +44 (0) 171 842 0260

E-mail : rob. fraser@riskmetrics .com

Credit Derivatives are continuing to enjoy major growth in the financial markets, aided

and abetted by sophisticated product development and the expansion of product

applications beyond price management to the strategic management of portfolio risk. As

Blythe Masters, global head of credit derivatives marketing at J.P. Morgan in New York

points out: “In bypassing barriers between different classes, maturities, rating categories,

debt seniority levels and so on, credit derivatives are creating enormous opportunities to

exploit and profit from associated discontinuities in the pricing of credit risk”.

With such intense and rapid product development Risk Publications is delighted to

introduce the first Guide to Credit Derivatives, a joint project with J.P. Morgan, a

pioneer in the use of credit derivatives, with contributions from the RiskMetrics Group,

a leading provider of risk management research, data, software, and education.

The guide will be of great value to risk managers addressing portfolio concentration risk,

issuers seeking to minimise the cost of liquidity in the debt capital markets and investors

pursuing assets that offer attractive relative value.

Introduction

With roots in commercial, investment, and merchant banking, J.P.Morgan today is a

global financial leader transformed in scope and strength. We offer sophisticated

financial services to companies, governments, institutions, and individuals, advising on

corporate strategy and structure; raising equity and debt capital; managing complex

investment portfolios; and providing access to developed and emerging financial

markets.

J.P. Morgan’s performance for clients affirms our position as a top underwriter and

dealer in the fixed-income and credit markets; our unmatched derivatives and emerging

markets capabilities; our global expertise in advising on mergers and acquisitions;

leadership in institutional asset management; and our premier position in serving

individuals with substantial wealth.

We aim to perform with such commitment, speed, and effect that when our clients have a

critical financial need, they turn first to us. We act with singular determination to

leverage our talent, franchise, résumé, and reputation - a whole that is greater than the

sum of its parts - to help our clients achieve their goals.

Leadership in credit derivatives

J.P. Morgan has been at the forefront of derivatives activity over the past two

decades. Today the firm is a pioneer in the use of credit derivatives - financial

instruments that are changing the way companies, financial institutions, and investors

in measure and manage credit risk.

As the following pages describe, activity in credit derivatives is accelerating as users

recognise the growing importance of managing credit risk and apply a range of

derivatives techniques to the task. J.P. Morgan is proud to have led the way in

developing these tools - from credit default swaps to securitisation vehicles such as

BISTRO - widely acclaimed as one of the most innovative financial structures in

recent years.

We at J.P. Morgan are pleased to sponsor this Guide to Credit Derivatives, published

in association with Risk magazine, which we hope will promote understanding of

these important new financial tools and contribute to the development of this activity,

particularly among end-users.

In the face of stiff competition, Risk magazine readers voted J.P. Morgan as the highest overall

performer in credit derivatives rankings. J.P. Morgan was was placed:

About J.P. Morgan

1sr credit default swaps - investment grade

1st credit default options

1st exotic credit derivatives

2nd credit default swaps - emerging

2nd basket default swaps

2nd credit-linked notes

For further information, please contact:

J.P. Morgan Securities Inc

Blythe Masters (New York)

Tel: +1 (212) 648 1432

E-mail: [email protected]

J. P. Morgan Securities Ltd

Jane Herring (London)

Tel: +44 (0) 171 779 2070

E-mail: [email protected]

J. P. Morgan Securities (Asia) Ltd

Muneto Ikeda (Tokyo)

Tel: +81 (3) 5573-1736

E-mail: [email protected]

C reditM e trics

Launched in 1997 and sponsored by over 25 leading global financial institutions,

CreditM e trics is the benchm a rk in managing the risk of credit portfolios. Backed

by an open and transparent me thodology, CreditM e trics enables users to assess the

overall level of credit risk in their portfolios, as we ll to identify identify ing risk

concentrations, and to compute both economic and regulatory capital.

CreditM e trics is currently used by over 100 clients around the world including

banks, insurance companies, asset managers, corporates and regulatory capital.

C reditManager

CreditManager is the softwa re implementation of CreditM e trics, built and

supported by the RiskM e trics G roup.

Implementable on a desk-top PC, CreditM anager allows users to capture, calculate

and display the inform a tion they need to manage the risk of individual credit

derivatives, or a portfolio of credits. CreditM anager handles most credit

instruments including bonds, loans, com mitments, letter of credit, market-driven

instruments such as swaps and forwards, as we ll as the credit derivatives as

discussed in this guide. W ith a direct link to the CreditManager website, users of

the software gain access to valuable credit data including transition m a trices,

default rates, spreads, and correlations. Like CreditM e trics, CreditManager is

now the world’s most widely used portfolio credit risk management system.

For more information on CreditMetrics and CreditManager, including the

Introduction to CreditMetrics, the CreditMetrics Technical Document, a demo of

CreditManager, and a variety of credit data, please visit the RiskMetrics Groups

website at www.riskmetrics.com, or contact us at:

Sarah Xie Rob Fraser

RiskMetrics Group RiskMetrics Group

44 Wall St. 150 Fleet St.

New York, NY 10005 London ECA4 2DQ

Tel: +1 (212) 981 7475 Tel: +44 (0) 171 842 0260

1. Background and overview: The case for credit derivatives

What are credit derivatives?

D e riva tives grow th in the latter part of the 1990s continues along at least three

dimensions. Firstly , new p roducts are em e rging as the traditional building

blocks – forw a rds and options – have spawned second and third generation

derivatives that span com p lex hybrid, contingent, and path-dependent risks.

Secondly, new app lica tions are expanding derivatives use beyond the specific

managemen t of price and event risk to the stra tegic managemen t of portfolio

risk, balance sheet grow th, shareholder value, and overall business

performance . Finally , derivatives are being extended beyond m a instream

interest rate, currency , com m odity , and equity m arkets to new underly ing risks

including catastrophe, pollution, electricity , inflation, and credit.

Credit derivatives fit neatly into this three-dimen sional schem e . Until recently,

credit rem a ined one of the m a jor components of business risk for w h ich no

tailored risk-managemen t products existed. Credit risk managemen t for the

loan portfolio manager mean t a strategy of portfolio diversification backed by

line lim its, w ith an occasional sale of positions in the secondary m a rket.

D e riva tives users relied on purchasing insurance, letters of credit, or guarantees,

or negotiating colla teralized ma rk-to-m a rket credit enhancemen t provisions in

Master Agreements. Co rporates either carried open exposures to key

customers’ accounts receivable or purchased insurance, where available, from

factors. Y e t these stra tegies are inefficient, largely because they do not separate

the managemen t of credit risk from the asset w ith wh ich that risk is associated.

For example, consider a corporate bond, which represents a bundle of risks, including

perhaps duration, convexity, callability, and credit risk (constituting both the risk of

default and the risk of volatility in credit spreads). If the only way to adjust credit risk

is to buy or sell that bond, and consequently affect positioning across the entire bundle

of risks, there is a clear inefficiency. Fixed income derivatives introduced the ability

to manage duration, convexity, and callability independently of bond positions; credit

derivatives complete the process by allowing the independent management of default

or credit spread risk.

Formally, credit derivatives are bilateral financial contracts that isolate specific aspects

of credit risk from an underlying instrument and transfer that risk between two parties.

In so doing, credit derivatives separate the ownership and management of credit risk

from other qualitative and quantitative aspects of ownership of financial assets. Thus,

credit derivatives share one of the key features of historically successful derivatives

products, which is the potential to achieve efficiency gains through a process of market

completion. Efficiency gains arising from disaggregating risk are best illustrated by

imagining an auction process in which an auctioneer sells a number of risks, each to

the highest bidder, as compared to selling a “job lot” of the same risks to the highest

bidder for the entire package. In most cases, the separate auctions will yield a higher

aggregate sale price than the job lot. By separating specific aspects of credit risk from

other risks, credit derivatives allow even the most illiquid credit exposures to be

transferred from portfolios that have but don’t want the risk to those that want but

don’t have that risk, even when the underlying asset itself could not have been

transferred in the same way.

What is the significance of credit derivatives?

Even today, we cannot yet argue that credit risk is, on the whole, “actively” managed.

Indeed, even in the largest banks, credit risk management is often little more than a

process of setting and adhering to notional exposure limits and pursuing limited

opportunities for portfolio diversification. In recent years, stiff competition among

lenders, a tendency by some banks to treat lending as a loss-leading cost of relationship

development, and a benign credit cycle have combined to subject bank loan credit spreads

to relentless downward pressure, both on an absolute basis and relative to other asset

classes. At the same time, secondary market illiquidity, relationship constraints, and the

luxury of cost rather than mark-to-market accounting have made active portfolio

management either impossible or unattractive. Consequently, the vast majority of bank

loans reside where they are originated until maturity. In 1996, primary loan syndication

origination in the U.S. alone exceeded $900 billion, while secondary loan market volumes

were less than $45 billion.